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Concluding Remarks of 2000 Article IV Consultation -- Canada

November 16, 1999

At the conclusion
of annual Article IV bilateral discussions with the
authorities, and prior to the preparation of the staff's report to the Executive Board, the IMF
mission often provides the authorities with a statement of its preliminary findings.

1. As the Canadian economy marks its eighth consecutive year of expansion, its strong performance has been underpinned by the sound macroeconomic and structural policies implemented and sustained during the 1990s. Inflation has been maintained at very low levels as a result of the Bank of Canada's successful inflation targeting policy. Sharp improvements in provincial and federal fiscal balances have resulted in a decline in the ratio of government debt to GDP in recent years, and the prospects are good for further reductions over the medium term. Important structural reforms have been adopted, including improvements in the employment insurance system, the more complete financing of the public old-age support system, the continuing removal of barriers to interprovincial trade, and a restructuring of provincial social assistance programs. These policy efforts have been reflected in low and stable inflation expectations, significant reductions in real and nominal interest rates, a stable external position-with the external current account shifting rapidly toward surplus as commodity prices recover-and a drop in the unemployment rate to its lowest level in a decade. The authorities are to be highly commended for these achievements.

2. Although aggregate resource utilization has risen significantly in the last year, there is considerable uncertainty as to how much slack remains in the economy. Estimates of the output and employment gaps range widely, and do not provide firm guidance on exactly how far the economy might be from full capacity. The high level of investments in new technologies and machinery and equipment during recent years may have raised the level of capacity. The reforms in the Employment Insurance (EI) system and in provincial social assistance programs also are likely to have contributed to ongoing reductions in structural unemployment. The economy has been growing at a rapid pace, raising the prospect that any remaining slack might be exhausted quite quickly, although core inflation has so far remained well-contained. Prospects for growth are also highly dependent on changes in the external environment that Canada faces-particularly developments in the United States.

3. In these circumstances, the IMF staff agrees with the Bank of Canada that the near-term aim of monetary policy should be to allow the economy to seek its productive potential without compromising the official target for inflation. A key policy challenge in pursuing this objective will be to gauge the point at which monetary conditions need to be less accommodative as slack in the economy appears to diminish and indications of inflationary pressures begin to emerge. The authorities' success in maintaining low inflation has established the credibility of the targeting regime, helping to firmly anchor inflation expectations. This credibility is reinforced by the favorable medium-term fiscal outlook and the prospects for further debt reduction. These achievements provide the Bank with somewhat more room to maneuver in testing the economy's productive limits. Nevertheless, it will be important to ensure that the limits of potential output are not approached with undue speed in order to minimize the risk of hitting capacity constraints before monetary policy has sufficient time to work to rein in excess demand pressures. In judging how Canadian monetary policy should respond to developments in the United States, the key consideration will be the extent to which continued rapid U.S. growth could add to rapid demand growth in Canada and contribute to a spillover of inflationary pressures. In this context, the Bank of Canada's careful monitoring of a range of early warning indicators, and its commitment to a prompt and firm response should signs of price and cost pressures emerge, is appropriate.

4. Fiscal policy needs to maintain a medium-term focus to bring down the ratio of government debt to GDP, which remains among the highest of the large industrial countries. The Government's presentation of five-year budget projections in its recent Economic and Fiscal Update, derived as the average of forecasts prepared by four major private forecasting firms, is a welcome step that should help to enhance the quality of the public debate on feasible fiscal policy options. The IMF staff's fiscal outlook, assuming current tax and spending policies, is broadly in line with that contained in the update. While the federal government's budgetary position is sound, it is important to bear in mind that the surpluses available over the next five years are not unlimited. Moreover, a part of the projected surplus stems from the automatic rise in the real burden of personal income taxes owing to the lack of full indexation to inflation. Therefore, careful choices will have to be made in deciding the mix of policy actions to be adopted.

5. The IMF staff believes that debt reduction and income tax reform should be the top priorities in allocating the prospective fiscal surpluses. While some additional moderate spending initiatives in the areas of education and health care would be useful, debt reduction and reform of income taxation are likely to produce more significant long-term benefits for the economy. Looming uncertainties regarding the longer-term fiscal cost of an aging population (especially in the area of health care) suggest that it would be prudent to target somewhat larger government savings now in order to better prepare for these future costs. Therefore, the Government should seize the opportunity afforded by relatively favorable economic conditions to accelerate the reduction in the debt-to-GDP ratio by running somewhat larger annual surpluses than the $3 billion that would occur if the contingency reserve is not spent each year. This could be achieved, for example, by devoting to debt reduction, in addition to the unspent contingency reserve, the surplus funding available each year as a result of a stronger-than-expected economy (the "economic prudence" margin in the fiscal estimates, as well as any additional unanticipated favorable budget outcomes).

6. On the tax side, reducing the high burden of personal and corporate income taxes offers considerable scope for economic efficiency gains. Therefore, the IMF staff strongly supports the Government's intention to introduce a multi-year plan to cut income taxes. Federal efforts toward reforming the income tax system should be coordinated with provincial governments to ensure that tax reductions are not offset by actions in the provinces.

7. High average and marginal personal income tax rates (with the highest effective marginal rates falling on middle income taxpayers) have contributed to disincentives to work and save. Although there is an extensive menu of possible measures from which to assemble a multi-year tax-cut package, the IMF staff takes the view that personal income tax reform should include steps to ensure full inflation indexation of the system; to increase the income thresholds at which progressive marginal tax rates apply; to cut the 26 percent statutory marginal tax rate; and to reduce the clawback of the National Child Benefit. In particular, such steps would ease the very high marginal effective tax rates on middle-income workers.

8. The corporate income tax system imposes tax rates that are high by international standards (particularly in a key growth sector such as services). An appropriate first step would be to lower the basic federal corporate income tax rate, which would serve to make the system more neutral and less distortionary by reducing the higher taxation of income outside the small business and manufacturing and processing sectors. Consideration also needs to be given to some of the recommendations in the 1998 Report of the Technical Committee on Business Taxation with respect to broadening the tax base, reducing compliance costs, and improving tax enforcement.

9. Significant progress has been made toward balancing the budgets of the provincial governments since 1993, and each province remains committed to implementing its own plan to maintain, or to achieve, budget balance or surplus by 2000. With a rebound in commodity prices, higher federal transfers, and the outlook for sustained growth across Canada, the aggregate fiscal position of the provinces appears poised to be at least in balance in the period ahead. This level of fiscal effort may well need to be strengthened in coming years in order to prepare for the longer-term fiscal costs associated with an aging population.

10. Although the unemployment rate has been falling significantly, it remains high both by historical standards and in relation to the United States. Changes to the Employment Insurance system implemented in 1996, which included tying benefit levels to the frequency of use and sharper clawback provisions for higher-income participants, have contributed to improving the efficiency and flexibility of the labor market and to reducing structural unemployment. As the reforms have become binding, pressures have mounted to roll back these changes. It will be important to preserve the EI reforms to help the economy to operate at lower average levels of unemployment without sparking inflation. Additional steps could be taken to address the employment disincentives that remain in the EI system. In particular, further reductions in EI premiums could be implemented in a manner that ties premiums for individual firms to the use of the system by their workers (i.e., experience rating, similar to the approach taken in the case of provincial workers' compensation programs). Moreover, phasing out the system of regional extended unemployment benefits would help reduce the disincentives to labor mobility. The recent announcement of increased maternity and parental leave benefits to be funded through the EI system, together with a relaxation of the eligibility requirements, appears to be a step away from the idea that the EI system should be primarily an insurance scheme and could create new incentives for casual labor force participation.

11. Canada has demonstrated on numerous occasions its commitment to liberal trade through unilateral, regional, and multilateral initiatives, and continues to work for trade liberalization through multilateral and regional fora. While great strides have been made in reducing trade barriers, Canada retains high rates of protection in some sensitive sectors, such as agriculture and textiles and clothing. The IMF staff urges the authorities to continue to pursue trade liberalization, and encourages them to exceed current WTO obligations on liberalizing trade in agriculture and textiles and clothing, in order to enhance the efficiency of the Canadian economy and to improve economic prospects for many developing countries.

12. The IMF staff found a very sound and stable financial system in Canada, underpinned by strengthened balance sheets of banks and nonbanks. Banking, insurance, and securities regulation and supervision, and the payments system comply to a high degree with the major international principals and standards; indeed, Canada's experience is a source of best international practice in a number of areas. However, as in other major industrial countries with advanced banking systems, ongoing developments in financial markets will pose a number of challenges. The structure of the Canadian financial system is likely to continue to undergo rapid change, spurred by global competitive pressures, the demutualization of the life insurance industry, and the proposals for fostering domestic competition contained in the White Paper on reforming Canada's financial services sector. The changing nature of financial instruments_including the growing reliance on derivative and other off-balance sheet transactions, the securitization of assets in order to reduce the need for regulatory capital, and the rapid growth of life insurance segregated funds_could increase the volatility of income and heightens the importance of maintaining and developing further good risk management tools. Increased integration with financial markets in the United States is a natural development and offers the benefits of portfolio diversification. However, it does make the Canadian financial system more susceptible to shocks originating in U.S. real and financial markets and could entail some cross-border liquidity risks. The Canadian authorities are already substantially addressing these challenges through their well-developed supervisory framework-with its emphasis on a consolidated, risk-centered approach. In addition, the growing importance of the securities industry at both the federal and provincial levels suggests that coordinating and harmonizing the regulatory framework for the industry will require increasing attention.

13. The latest figures show that Canada_s official development assistance (ODA) as a share of GNP declined from 0.46 percent in 1992 to 0.29 percent in 1998. In this context, the IMF staff welcomes the Prime Minister's recent statement that the Government intends to increase foreign aid in the next budget, and encourages the authorities to move gradually toward achieving their long-standing commitment to reach a development-assistance target of 0.7 percent of GNP.